Nelli Oster, PhD, Investment Strategist, Multi-Asset Strategies Group, BlackRock
Stance: Too narrow a focus
When markets are choppy, lots of investors feel safer investing in names they recognize. But this bias may be more detrimental than dynamic. Canada forms only 4% of the MSCI All Country World Index, so investors seeking safe havens miss out on 96% of world equity market capitalization of mid- and large-cap companies. We advocate exposure to emerging markets, which are currently trading at an almost 30% discount, based on price-to-earnings, despite generally higher expectations for growth.
If you’re nervous about currency risk, sectors such as utilities and healthcare tend to have more domestic exposure.
Much of Canada’s equity market index is in resource-driven sectors that have high sensitivity to emerging markets. Consider how companies in these sectors hedge their currency exposure. Whether they use derivative contracts such as options should depend on companies’ assessments of their operating environments; the potential benefits of these strategies, such as lower earnings volatility; and their associated costs, which depend on the instruments used. Companies with less volatile earnings often have less volatile share prices and lower beta, or share price sensitivity to general market movements.
You take on two types of risk if you invest in an international market—local equity market volatility and currency fluctuations. Correlation between the two risks matters. When those measures move in the same direction, currency amplifies the shift and makes returns even more volatile. Other times, the correlation may be negative and currency changes can dampen volatility in local equity market returns.
That’s what we’re seeing in Japan. The central bank stepped in with an aggressive monetary policy, which has driven down the value of the yen.
For those invested in Japanese equities using the yen, returns would have been much higher than if you invested using the U.S. or Canadian dollar. Sophisticated investors may also use derivative instruments, such as forward currency contracts, options or futures to hedge their exposures. Alternatively, investors can choose between local-currency and Canadian-dollar products for exposure to the same markets.
In a recent analysis, we examined the impact of currency hedging in Canada between January 1980 and December 2011. Turns out holding exposures to foreign currencies—in an unhedged ETF, for example—can reduce portfolio volatility. In the 21-year period, unhedged foreign equity assets had lower volatility than hedged. From 1980 to 2001, unhedged assets had lower volatility than hedged ones, but only marginally—perhaps owing to the political instability in Canada during this period.
Conversely, from 2002 to 2007, we saw hedged assets experience less volatility than unhedged. This was a period of general depreciation of the U.S. dollar, along with worsening economic fundamentals arising from the U.S. housing market slowdown. The Canadian dollar rose from 62 cents U.S. in 2002 to parity at the end of 2007.
However, from January 2008 to December 2011, unhedged assets were 5.5% less volatile.
We’ve witnessed a risk-on, risk-off trading environment since the financial crisis began. Currencies, like asset classes, were highly correlated during that period.
And given that there wasn’t much dispersion among currencies, it was harder finding investment opportunities for investors trading solely in currencies. We’re starting to see systemic risk—especially tail risk out of Europe—abating. Thanks to central bank policies in countries like Japan, currencies have started trading more in line with the fundamentals of local economies.
That makes it easier for investors to express their views on specific markets, rather than react to global systemic risk.
Garnet Anderson, CA, CFA, Portfolio Manager, Tacita Capital Inc.
Stance: Currency volatility can be hedged
For many Canadians, home bias is driven by tax advantages to invest your taxable accounts here.
To invest solely in Canada because of anxiety over currency is not a wise move, especially in today’s markets, when you can divorce country and regional equity exposure from currency exposure.
An array of vehicles—from ETFs to mutual and hedge funds—come with imbedded currency hedging. A fund can periodically calculate its various currency exposures and adjust futures accordingly. A fund’s approach to currency hedging is often outlined in the vehicle’s objectives, and the hedging positions are listed in the financials. Investors should get comfortable with underlying investments before obsessing about currency; which really is a byproduct of an overall asset mix.
It’s difficult to consistently make money on a currency overlay strategy where investors, for example, take 5% of their capital and invest it into the futures market, and hope to earn a solid, risk-adjusted rate of return on that 5%.
A starting point for an equity allocation is often 30% each to Canada, US and international, with the balance in emerging markets. We don’t hedge our emerging market equity exposure because those are fast-growing economies and over the long run their currencies should do relatively well. For emerging markets, there’s an array of factors we keep an eye on:
- Economic growth and interest rates: all else being equal, a higher-growth economy or one offering higher real interest rates should see an uptick in its currency. That’s why we keep an eye on nominal interest rates (are they low and stimulating an economy?).
- Yield curves: a flattening yield curve is usually a precursor to recession.
- Inflation: it’s often a by-product of where a country sits in its economic cycle.
While identifying a longer-term currency trend helps set hedge ratios at the portfolio level, we rely on our allocation to managed futures to take advantage of short-term currency oscillations and mini-trends.
For U.S. and international equities, our strategic position is to be 30% hedged and 70% un-hedged. Based on our sense of whether a currency is depressed or overvalued, we change that hedge ratio. Since it’s difficult to predict, we often use new cash-flow events—such as dividends, bond coupon payments, and client savings and withdrawals—to adjust the targeted ratio as opposed to outright buying and selling.
In the short term, the currency volatility can particularly impact fixed-income returns.
If interest rates are at 2% and currency fluctuations at 5% or 6%, those fluctuations can swamp fixed-income returns. For that reason, short-term investors have to be cognizant of what foreign currency risks they’re bringing into their portfolios.
If Canadian investors have non-hedged, non-Canadian-dollar-denominated bonds, they should have a good reason. Do they have them because they’ll ultimately need the currency they’re invested in? Maybe they have a retirement home in Florida. In that case, a U.S.-currency bond would make absolute sense.
For balanced investors who are willing to accept more volatility, there is currency diversification. You’ll want some winners to offset the laggards. For example, the Canadian dollar may be up against the yen, flat with the pound and down against the euro, all of which could smooth out the Canadian-dollar return pattern of the international equity allocation in a portfolio.
Ebb and flow
When you’re in the middle of a material low cycle, you need to be very aware of your hedging strategy because depressed currencies tend to recover—think of the Canadian dollar. Unhedged investors were very disappointed with the Canadian-dollar returns of their foreign holdings when the CAD reached parity in 2007.
Kanupriya Vashisht is a Toronto-based financial writer.